Fancy A Gamble?

This article “Fancy A Gamble?” by Cai HaoXiang was first published in The Business Times on 20 Feb 2017 and is reproduced in this blog in its entirety.

Stock speculation can be rational and intelligent, but the value investor should moderate the degree

Some 10 days ago, I joined a long line of Singaporeans in a Singapore Pools outlet in an annual gambling ritual, the Toto Hongbao Draw.

It’s a donation to charity, I tell myself. I know my chances of winning anything are as good as zero. In all my years of sporadically buying lottery tickets, I have never won a single cent. And indeed, I didn’t.

Moreover, statistical calculations tell me that ever since the Toto system was changed in 2014 from choosing six digits from a pool of 45 numbers to choosing six digits from a pool of 49 numbers, punters have been getting a poorer deal out of the money they commit to every draw.

Not that it matters. There lies within us a desire to earn a lot of money through minimal effort. I tell myself I am buying hope, but who am I kidding?

It is human nature. We are willing to spend S$100 a year for 10 years for a near-zero shot at winning S$1 million. But we are often unwilling to spend some time studying stocks so we can invest S$1,000 wisely.

Even if we had S$1,000 to invest, we would rather punt it on a stock that is going up.

Defining Speculation

Talk to most people about stocks, and they will say that buying them is like gambling.

This is as if buying shares in a global conglomerate with numerous visible businesses and a dividend payment record stretching back decades is no better than buying a S$1 Quickpick Ordinary ticket at the Toto Hongbao draw with an expected return of -46 per cent.

Talk to any self-professed value investor, on the other hand, and he will tell you in a haughty tone: “I’m a long-term investor, not a speculator.”

What’s going on? Why would people think investing is gambling, and why would some investors prefer to think of other stock market players as gambling? Is speculation that bad? Is all value investing devoid of speculative behaviour?

The investing-speculation distinction has been brought up in financial writings throughout the decades. Students of value investing gurus Benjamin Graham and David Dodd will remember numerous references in their landmark 1934 textbook, Security Analysis.

Graham and Dodd first speak of speculation as buying businesses that are “subject to substantial uncertainty and risk”.

They quickly caution that analysing such speculative businesses has a number of disadvantages. “The underlying analytical factors in speculative situations are subject to swift and sudden revision. The danger, already referred to, that the intrinsic value may change before the market price reflects that value, is therefore much more serious in speculative than in investment situations,” they wrote.

Too many unknown factors that can determine a stock’s fate is regarded as a negative, they said.

The two authors will go on to describe the difference between “intelligent speculation” and “unintelligent speculation”.

Intelligent speculation is taking on a risk “that appears justified after careful weighing of the pros and cons”. Unintelligent speculation is “risk taking without adequate study of the situation”.

It might seem that the line between an “investment” business and a “speculation” business is clear cut. As long as one spends more time thinking about a business, one is speculating intelligently.

But I think a lot about my odds (or lack thereof) of winning Toto too. Am I gambling intelligently, then?

Analysts often think they know a lot about a company. But their knowledge sometimes makes them overconfident.

Moreover, lest you think that only penny stocks are subject to speculation, Graham and Dodd will disabuse you of the notion.

Sound, mature, healthy businesses can trade at speculative prices, too. Graham and Dodd even said that intrinsic value, defined as “value justified by the facts”, may include both an “investment” component and a “substantial component of speculative value, provided that such speculative value is intelligently arrived at”.

“Hence the market price may be said to exceed intrinsic value only when the market price is clearly the reflection of unintelligent speculation,” they said.

Value investors using an intrinsic value framework can be speculating, too.

Concrete Examples

All this might still sound fuzzy. Yet the authors did offer examples of what they considered speculation.

One interesting remark was how a stock trading at more than 20 times earnings is speculatively priced. Meanwhile, a company with neutral prospects can be reasonably purchased at 12 to 12.5 times earnings, provided its financial structure, management and prospects are also satisfactory.

“People who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose considerable money in the long run,” they wrote.

They are not mistaken. Studies have shown that stocks with low price-to-earnings (PE) ratios, on aggregate, tend to outperform stocks purchased at high PE ratios.

The number 20 still makes sense in today’s environment. A 20 times earnings ratio implies an earnings yield of 5 per cent. Graham and Dodd wrote their textbook at a time when safe Treasury bonds yielded between 2-4 per cent, which is not far from where they are today.

An earnings yield below 5 per cent, where the PE is above 20, might not be deemed as sufficiently reasonable a return when safe investments can already yield a few percentage points.

One should not mistake a year or two of good earnings as representative of the future. But the opposite also applies, where certain companies can reasonably be expected to see their earnings recover.

But going by the 20-times PE metric, a large number of tech-related businesses, Facebook, Alibaba and Amazon among them, can be rightly described as speculative. Whether investors are intelligently or unintelligently taking risks is another issue altogether.

A second interesting remark about speculative stocks Graham and Dodd made was how some stocks benefit from having a “speculative capitalisation structure”.

Such highly-leveraged companies, when trading at depressed levels, “can advance much further than they can decline”.

This observation will ring true when one casts an eye at a number of indebted oil and gas counters trading on the Singapore Exchange.

While priced for liquidation scenarios, such counters can be poised for a remarkable recovery when it is clear they have sufficient financial strength to ride through a business downturn.

Another example is Catalist-listed interior fitting-out firm Serrano, which soared more than 30 times from S$0.002 to above S$0.07 once it seemed the firm was going to get bailed out by other investors.

Does it mean Serrano was a value investment at S$0.002 or S$0.003? Looking at its financial statements, one would say no. It has not proven that it can run a successful business.

There still remains a sizeable risk of its business going under despite a capital injection. But speculators, in the days after the company’s proposed placement to investors was announced, had a field day.

Third, companies with a high cost of production relative to its competitors are also deemed by Graham and Dodd to be speculative.

The reasoning here is that such companies tend to report lower earnings and result in a lower stock valuation. But should the price of what the company is selling rise – commodities being an obvious example – profits of high-cost producers will surge much more than that of low-cost producers.

The Role Of Value

Debt-laden, high-cost businesses trading at over 20 times earnings might justifiably be described as speculative investments. Buy businesses like that, and we should recognise that we are speculating.

However, such speculation might not be necessarily irrational. Much depends on the individual circumstances of a company.

To sleep soundly at night though, the investor subscribing to a value philosophy should arguably avoid such securities, or at least limit their presence in a portfolio.

Speculation, after all, is not something conservative-minded investors should be doing liberally.

And it can be difficult to figure out how to speculate intelligently. One might not fully appreciate the cons of an investment while being beguiled by the pros. It might take too much time, or one might not have enough experience, to decide whether some risks are worth taking.

Investors following a value philosophy have to make a conscious decision to stay away from “hot” stocks, stocks with unproven growth potential, and even stable stocks trading at over-generous valuations.

After all, as Graham and Dodd noted, and which all gamblers and Toto buyers alike can appreciate:

“The investor of small means is privileged, of course, to step out of his role and become a speculator.